The Long or Short of It
Craig Hackler, Financial Advisor, Raymond James Financial Services
Consider Fred and Wilma. They
are anxious to become the
owners of a prestigious house.
Naturally, they are both positively bubbling
over with excitement. Wilma, in particular,
can barely restrain her enthusiasm
for the home of her dreams. However, she
has the financial brain of the couple and
wants to make the best possible choice for
mortgage financing. She must choose
between a 15 year mortgage at 5% and a 30
year mortgage at 5.5%. In either case, they
will borrow $100,000, pay the same in
closing costs and neither mortgage note
has a prepayment penalty.
A quick analysis of their situation
reveals that their monthly payment on the
15 year mortgage (principal and interest
only) will be $791. Over the course of the
mortgage they will pay $42,343 in interest.
Of course, that interest is deductible. Let’s
assume that Fred and Wilma will be in the
25% tax bracket for the next 30 years. That
means, after-tax, the interest costs them
$31,757. Their total after tax payments will
be $131,756. Interest on debt sure adds up
over time doesn’t it?
The 30 year mortgage results in monthly
payments of $568. Total interest payments
will be a whopping $104,404. But,
thanks to the deduction Uncle Sam gives
them, the after tax-cost of the interest is
“only” $78,303 making their total after tax
payments equal to $178,303. The 30 year
mortgage gives them payments that are
lower by $223 but it costs them $46,547
more, after-tax.
One answer would be to take the sure
thing, borrow for 15 years and run. But,
consider the flexibility of the 30 year mortgage.
If they were to invest the $223 per
month in common stocks that returned
6%, after tax, for 15 years they would have
over $65,177. The balance due on their 30
year mortgage after 15 years is about
$69,490. Within the next 8 months, they
will actually have more saved than their
balance due on their mortgage. The key to
this strategy is Fred and Wilma must actually
save the $223 each and every month. If
they don’t, they may have been better off
with the “forced savings” imposed by the
15 year mortgage. Investing involves risk
and you may incur a profit or a loss. The
examples provided are hypothetical and
do not suggest or guarantee particular
rates of return for any investment. The
examples do not include transaction costs
and tax considerations that would reduce
an investor’s return.
How about these three alternative
strategies that take advantage of the inherent
flexibility of a 30 year mortgage with
no prepayment penalty. If Fred and Wilma
make 13 payments every year, starting in
the first year, the extra $567.79 will reduce
their after-tax interest cost to $63,478 and
pay off the mortgage about 5 years ahead
of schedule.
As an alternative, they might pay the
next month’s principal along with each
payment. For example, with their first payment,
they would also pay the $110 in
principal that would otherwise have been
due on their second payment. Every
month they would pay a little more in
extra principal. This strategy results in
after-tax interest costs of $44,529 and a
pay-off in year 18, a little over 13 years
ahead of schedule.
A simpler alternative would be to send
a flat amount along with each month’s
mortgage payment. Sending $100 per
month would reduce their after-tax interest
cost to $51,990 and pay off the mortgage
about 8 years early. Each of these
alternatives requires discipline. If one does
not have the discipline to actually send the
mortgage lender the additional funds then
the forced savings of the 15 year mortgage
might be the best bet.
Of course, this brief article is no substitute
for a careful consideration of all of the
advantages and disadvantages of this matter
in light of your unique personal circumstances.
Before implementing any significant
tax or financial planning strategy,
contact your financial planner, attorney or
tax advisor as appropriate.
Craig Hackler holds the Series 7 and Series
63 Securities licenses, as well as the Group
I Insurance license (life, health, annuities).
Through Raymond James Financial Services,
he offers complete financial planning
and investment products tailored to
the individual needs of his clients. He will
gladly answer your questions. Call him at
512.894.0574 or 800.650.9517.
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